In this article, the discussion is an overview of the Re-Advanceable Line of Credit and the Smith Manoeuvre, a technique or option to make your mortgage tax deductible and create access to incremental funds for investment (or any) purposes.
"Smith Manoeuvre" - the General Thought
- Fraser Smith, for whom the Smith Manoeuvre is named, created a tax strategy that converts regular debt into tax-deductible debt and claims to cut mortgage payoff time in 1/2, while helping the client invest more, sooner.
- Leverage, as it relates to financial matters, means you borrow money at a lower interest rate and invest it to earn a higher return than your cost of money. The difference or "spread" is your leveraged profit.
- Suggesting leverage for investment purposes can be sticky advice for financial planners to give and risky for ill-informed investors to pursue.
- For many clients, however, having the option to leverage or simply having access to cash to seize other opportunities or address needs as they arise is very valid, and there is an excellent mortgage product for this purpose, called a Re-advancable Home Equity Line of Credit (HELOC)
Readvanceable Line of Credit & Mortgage
Personally, I really like the re-advanceable line of credit. It is a mortgage product that allows the borrower to aggressively pay down their mortgage principal balance without loosing access to those pay down funds in the event there is an opportunity or requirement for those funds down the road, whereupon the borrower can re-borrow all or some of the re-paid principal amount simply by writing a cheque.
A readvanceable mortgage consists of a mortgage and a Home Equity Line of Credit (HELOC) packaged together with a global (combined) debt maximum set at a maximum of 80% of the value of the house.
With every monthly or extra mortgage payment made by the borrower, the mortgage principal is reduced by a certain amount, and the funds available to the borrower under the HELOC go up (are re-advanced) by the exact same amount. The borrower is not obligated to access the HELOC funds, but they easily can when the need arises. I find this would encourage me to pay my mortgage down faster knowing I can access the funds in an emergency, like job loss, etc. For others, you might be like a kid in a candy store and access to easy credit just too tempting!
The “Smith Maneuver” and Canadian Tax Law
If an investor borrows funds (from the HELOC in this case) to make an investment in Canada, the interest payments on the HELOC amount borrowed are tax-deductible, provided they can be clearly documented and are not commingled with other non-investment uses of the funds.
If an investor owns non-RRSP investments already (rental property, stocks, bonds, etc.), the objective is to sell these assets gradually* over time, use the proceeds to pay down the mortgage, then re borrow the funds and make new investments gradually* over time. Now your personal mortgage balance will be much smaller hence much lower interest expense, and your HELOC balance will be higher, but your overall debt is the same.
Important to note is interest on personal mortgage is not tax deductible because CRA does not consider your home an investment. However, when you re borrow the funds on the HELOC and make new investments, that interest is now tax deductible. You have now - thanks to Fraser Smith - converted non-tax deductible interest expense to a tax deductible mortgage via the Smith Maneuver (alternate spelling).
*I use the term "gradually" above because the CRA is watching for overt tax avoidance or abuse of the tax laws.
- The Smith Manoeuvre is indeed a powerful strategy, but it's not for everyone.
- There are both investment risks and serious tax risks.
- The client's investment returns could be insufficient,
- CRA could invalidate the application of the strategy, or
- The client could wind up in a negative amortization scenario if their house value falls.
- Anyone tempted to participate in the Smith Manoeuvre or other strategies to try and make interest on a home mortgage tax-deductible should obtain tax advice from a qualified accountant or tax lawyer whose only offering is unbiased advice.
- There has been a decisive court ruling on the strategy, which - in essence - said that avoiding tax is generally acceptable except when the tax avoidance is "abusive", so the application is critical.
Steps for Client to Make a Tax Deductible Mortgage
- First obtain a re-advanceable mortgage (combination of a mortgage and a line of credit (LOC).)
- Over time, sell any non-registered assets (like stocks held outside of an RRSP) acquired with non-borrowed money.
- Use these proceeds to pay down your mortgage (or increase your down payment on a purchase/refinance.)
- (Re-)invest this LOC money at a higher rate of return than the interest paid on the LOC.
- Also continue to make regular mortgage payments - the principal component automatically "re advances" (is made available) to the LOC.
- Interest on the investment loan (LOC) is now tax deductible. Calculate this tax savings and use the tax refund to further pay down your mortgage .
- Repeat steps 2-7 until your mortgage is fully paid off, potentially in half the time, or you have a sizeable investment far in excess of your mortgage balance.
From a Mortgage Planner's Point of View...
- If you do not own investments outside of your RRSP, this is not a strategy for you, per se.
- However, with a re-advanceable mortgage you can still create options (future flexibility), which can serve a number of purposes including tax deductibility, emergency funds, job loss, etc.
- Even if not immediately applicable, if a situation changes, the client may be glad they have the option/extra flexibility.
- At this exact moment,
- I am personally very comfortable knowing I have access to capital via my sizable and unused re-advanceable mortgage balance that I can tap on a moment's notice and that will be tax-deductible in any investment situation.
- If there is an emergency, I've got an emergency fund.
- Finally, I'm not afraid to pack away spare cash against the mortgage, knowing it's immediately re-advanceable.
If you or your client, friends or associates have any questions on this or any mortgage situation or need, please feel free to contact us.